10.25.2011

The Psychology of the Flat Tax

The article that follows covers both of these topics. You have been warned.

Lately it seems we have been hearing a lot of talk about taxes. The economy is in the crapper, people are scrambling to make ends meet, and each republican presidential hopeful is touting his or her tax plan as the newest way to "fix" things. Herman Cain’s one-trick pony the “9-9-9 plan” – a plan that only a pizza baron could dream up – got things started. Not wanting to be outdone, Rick Perry just unveiled his plan for a “flat” tax of 20%2. In other words, folks the "flat tax" is definitely in fashion this season.

Hold on, what is a flat tax?

I'm glad you asked. Well, in the simplest terms, a flat tax is a set percentage of income that all Americans would be expected to pay to the federal government. Our current system is not a flat tax system and technically, any system with exemptions or deductions cannot be a true flat tax system.

Okay, I'm listening. Why would a candidate propose such a tax?

Glad you're with me. Flat taxes are intuitively appealing because they are easy for the average person to understand. Some people credit Herman Cain’s recent surge in the polls to his 9-9-9 plan. Most of that can be attributed to how catchy and intuitive it feels. Candidates (on both sides of the isle) often want to take something very complex (like our federal tax code) and reduce it to a soundbite that people can really latch onto and remember, especially on the campaign trail. This builds trust and liking in the voter toward said candidate. Flat taxes are not new. The idea of a flat tax comes up every now and again, usually during an election year -- perhaps most famously during both of billionaire Steve Forbes failed presidential campaigns (the fact that Forbes endorses Perry should come as no surprise). Turns out there is a reason the flat tax zombie just won't die, and it is rooted deeply in human psychology.

Flat taxes play heavily on our notions of what psychologists call Distributive Justice. You see, humans are a social species and rely on each other to survive. In our evolutionary past it was necessary for us to share resources to get along. Because of this, humans are very concerned with fairness. So much so, that some psychologists argue we have evolved a "cheater detection module" to help us catch others who aren't playing nice. So in other words people want to know that they are getting a fair shake and they are especially attuned to when this is not the case.

So people want fairness - no one disagrees with that - so we should be good at being fair, right?

Not quite. You see, there are many different types of distribution and all of them could be considered "fair" given the right set of circumstances. The three most common types of distribution are equality, equity, and need. These can be easily demonstrated by taking a walk into our evolutionary past…

Let’s imagine a small group of cave people. Their leader, lets call him “Aak,” leads a successful hunting expedition that results some large game to share with the group. When Aak and the other hunters get back to the cave they must decide how to divide that day’s kill. The following examples illustrate the three different types of distribution:

everyone gets an equal share of the animal (equality)

the cave people who helped with the catching, killing, cleaning, and cooking will get more of the animal and those who did not will get less of the animal or nothing to eat at all (equity)

some cave people, due to their circumstances (e.g., illness, malnourished) get more of the animal while more fortunate others (e.g., the healthy), get less (need)

Yeah, yeah. That makes sense. But what does this have to do with taxes?

Well, in case you haven’t figured this out yet, a flat tax by its nature suggests that equality is the way to go. Everyone, regardless of their personal characteristics or situation pays the same, equal, share. What’s more, proponents of the flat tax argue that it is the only truly equal form of division and progressive taxation, by contrast, is unequal and unfair. Progressive tax pundits (say that five times fast) counter with the argument that progressive taxation does meet criteria for equality when you take into account the fact that all people have to spend a certain amount of money to cover basic necessities. For poor people, most of their income is devoted to these things. For rich people, the surplus money - after the necessities have been taken care of - is often used to make more money in the form of interest gained on savings accounts, retirement accounts, and investments (many of which, have their own associated tax breaks). Therefore, it is unfair to ask poor people to pay the exact same percentage of income because it cuts into money that they need to survive. Which approach truly meets the standard of equality? I don't think there is a right or wrong answer that that question.

How does knowing about these norms help me?

The great thing about being aware of these norms is knowing how people manipulate them in order to serve their purpose. Let’s use the Occupy Wall Street stuff as an example. The OWS folks argue that currently 1% of the people in this country control a staggering percentage of the wealth and that this is not fair. This calls into question the basis of fairness used on both sides of the argument:

The liberal argument is that those who are more fortunate should give more back in the form of taxes to be used for programs for those who are less fortunate (the norm of need).

The conservative argument is that liberals want to “spread the wealth” Robin Hood style and take money from people who have earned it and give it to those who did not earn it (thereby violating the norm of equity).

Pretty neat huh? Same behavior, two very different interpretations of what is "fair in this situation".

Conservatives in the U.S. and in Western Countries (e.g., The UK) believe that a flat tax could result in economic growth. One potential reason for this enthusiasm is that many East Bloc countries have a flat tax system and have experienced considerable economic growth over the past few years (though critics point to the fact that it cannot be determined whether the introduction of capitalism, the flat tax, or both are responsible for growth). Proponents also cite the easy of filing taxes that would come with such a plan as compared to the nightmare that it currently is.

Opponents of the tax say that it unfairly benefits the rich in that it essentially taxes money once and would make earnings on investments essentially tax-free. Essentially, a flat tax would cripple most of the working poor in America and it would be necessary to have certain breaks and deductions in place were it to be instated3.

Others (on both sides of the isle) seem to think there is more merit in modifying the tax code we already have rather than starting from scratch. What do you think? Let us know in the comments.

1 Okay, so I do have a few fancy pieces of paper on my wall that suggest I know more about psychology than taxes, but they say nothing about how much more.

2Apparently Newt Gingrich and John Huntsman also have flat tax plans, but who really cares at this point?

3In fact, Perry’s plan isn’t a true flat tax because it allows people to choose to either pay their current income tax rate or the new 20% rate. So by the strictest definition it wouldn't be a flat tax.

Essentially that was my goal. I'm sure you are aware of the naturalistic fallacy. Essentially, that fallacy suggests that all things that are natural are not necessarily good. I think there should also be the simplistic fallacy. The simplest plan isn't always the best. Although the least complicated plan that is also still effective might be. Like Einstein said about theory: "It can scarcely be denied that the supreme goal of all theory is to make the irreducible basic elements as simple and as few as possible without having to surrender the adequate representation of a single datum of experience." You could easily replace "theory" with "tax plan" in that quote. That's essentially it.

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